How Do Loans Work?

Let’s be real, dealing with finances, especially those that have to do with loans, isn’t usually something that many people like to do or are even good at. There’s plenty of jargon and concepts that could be elusive, but don’t worry! This article will explain to you how loans work, along with everything you might need to learn about the process.

How Do Personal Loans Work?

The shortest way to explain this is that loans offer a double benefit, one to the borrower that needs money now and one for the lender that could make do without some money in order to gain a little extra in the future.

This happens as a result of interest, which is an amount of money calculated based on the initial borrowed amount (which is known as the principal) and is added to the final amount that the borrower has to return.

How to Choose a Suitable Loan?

To choose the right personal loan for yourself, you need to understand that there are different types of loans available, each with customized plans to suit the borrower, and these are as follows:

Secured Personal Loans

how do personal loans work

A secured personal loan is the type that includes collateral, something that you offer to give up to the lending entity in the case of a default (inability to repay the loan) as a token of guarantee and a way for them to protect themselves from risk. Collaterals include savings accounts, certificates of deposit, houses, and vehicles.

The benefit of secured loans is that their interest is usually a lot lower than unsecured ones, which makes sense, as the risk is not as high for the lender who knows they’ll be getting their money back one way or another.

Unsecured Personal Loans

As contrary to secured loans, unsecured ones don’t require collateral as a guarantee. These require more caution when navigating, as the borrower should always ask themselves why someone would be willing to risk lending their money.

Safe unsecured personal loan examples are auto loans, which treat your car as collateral. In the case that you default, the lending entity takes over your car. In the case that you opt for an unsecured loan with no means of collateral, you need to have a robust credit history, ranging from 670 to 739, according to the Experian bureau, to back the loan. Some even require the co-signer to have a good credit score as well.

However, you should bear in mind that failing to repay your unsecured loans could hurt your credit score. Also, if the lender doesn’t seem to care much about your credit score or your ability to pay back the debt, there’s a high chance that they’re in the habit of making predatory loans.

Fixed-rate Loans

Loans with a fixed rate maintain one interest rate and monthly payments for the entire duration of the loan (known as “term”). The advantage of this is that you’ll know exactly how much you have to pay each month, and you’ll be able to budget your expenses accordingly.

Adjustable-rate Loans

Loans with adjustable rates can have varying interest rates over time. Usually, their interest is lower than fixed-rate loans as they come with a risk as the interest could increase exponentially, and with it, the monthly payments you have to make. If you’re in luck, however, the interest will decrease and you’ll benefit from that difference. These loans are advisable if you predict that interest rates are going to decrease.

How Is Interest Calculated for Personal Loans?

what is bank loan

Interest rates are calculated based upon the principal that the lender offers to the borrower, and this could be done in multiple methods:

Simple

As the name implies, simple interest rates are calculated by multiplying the rate to the principal, and that’s what you have to pay each month. So, if you borrow $1,000 and the interest rate is 5% over one year, you would owe $1,050 when the year is over.

Compound

Compound interest rates are more common for savings accounts and credit cards. They work by imposing interest on the total amount each year (the principal plus the extra money added after the interest had been calculated).

For example, if you borrow $1,000, and the interest rate is 5% over a year, you would owe $1,050 at the end of the first year. Then, the second year’s owed amount would be calculated according to the $1,050, not the initial $1,000, which means that you’d owe $1,102.5 for the second year, and so on.

Amortized

Amortized interest rates help those who don’t have enough money to pay for a huge principal at the beginning of the loan but can pay larger amounts of interest. It’s based on the idea that the periodic payments take into account both the interest and principal, paying off the interest expense for the duration while dedicating the remaining amount to paying off the principal.

How to Apply for a Personal Loan?

what is personal loans

You can apply for loans by contacting lenders either online or in-person. You can try applying to your credit union or bank, but there is always the option of heading to specialized lenders like peer-to-peer services and mortgage brokers.

You submit an application that involves answering questions about yourself, including your ID, bank account, bank statements, social security number, and proof of having a job with regular income.

After that, the lender will assess your application to make a decision regarding whether or not you qualify for a loan. If your application is accepted, the money could either be sent to you or directly to the entity that you’re buying from.

Then, you begin repaying the loan after a month of receiving it, with the interest rate and regular payments according to your agreements -typically monthly payments.

What Are the Fees Associated with Loans?

how to choose a suitable loan

When you’re applying for a loan, there are a couple of fees that you’ll have to pay, including:

  • An application fee: This is typically for approving the loan.
  • Processing fee: This pays for the administrative procedures associated with the loan.
  • Origination fee: This one is common for mortgages, and it’s the cost of securing the loan.
  • Annual fee: These are common for credit cards. Annual fees are flat fees that you have to pay to the lender.
  • Late fee: If you are late for payments, a late fee will be imposed on you.
  • Prepayment fee: This one applies to car and home loans, and they’re imposed if you pay the loan off early.

It’s worth mentioning that lenders impose prepayment fees because they usually expect to get regular income from the interest you pay. So, they have to secure themselves in the case that you don’t comply.

Also, not every loan comes with the abovementioned fees, but you should be prepared for any extra amount that you have to pay when you’re taking a loan into consideration.

Final Thoughts

Hopefully, this article was helpful for you and explained more about loans, how do personal loans work, and everything related to the terms you’ll encounter when reading about them. Of course, rates and some rules may change with time and differing policies, but the main idea and mechanism remain the same.

About the Author

Lucy has over a decade of experience in finance. She is currently the content curator here at Perfect Payday.

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